Executive pay has been the subject of heated public debate for many years. The latest disclosures of CEO pay packets make media headlines, academics argue over the political and ethical ramifications, and companies agonise over reputational issues and bad press.
Only last week, the Financial Times ran an article arguing the case for “salary-only” pay for executives; the author argued that it would help to address the UK’s sluggish productivity problem and build a sustainable economy that would benefit everyone.
In truth, the question of how to structure bosses’ pay is something of a minefield for companies that want to attract the best managers. Stuck between paying appropriately and making sure they are not outgunned by their competitors, firms find themselves attempting to second-guess other companies’ offers, leading to pay inflation, the result of a “prisoners’ dilemma” where the results are sub-optimal from both companies’ and society’s perspectives.
The problem is only magnified when a boss fails and is unceremoniously dumped—yet often with a “golden goodbye” worth many times the average pay of other employees.
So what can we do to solve the conundrum of executive pay? Firstly, we should agree that one of the problems lies in the widespread reliance on out-of-date financial theories firmly grounded in the “principal-agent” model. This framework assumes that executives are wholly self-interested, fully rational and solely financially motivated, and argues that, to encourage executives to perform in the best interests of shareholders, organisations must provide high-powered, performance-based incentives.
However, despite the elegance of the mathematical modelling, agency theory fails to take into account other factors beyond financial reward, which are relevant to the motivation and psychological engagement of those at the top of organisations.
The argument for maintaining the status quo is further undermined when it is recognised that conventional wisdom is not supported either by empirical research nor in practice. Numerous studies have concluded that there is little evidence of a statistically significant connection between executive pay and performance.
Indeed, far from finding long-term incentives motivating, many executives I encountered during my years with PwC raised the same common concerns—they frequently believed that long-term incentive arrangements were overly complex and they didn’t understand the real value of the rewards on offer.
As part of my research on executive pay, I surveyed 756 international senior executives about their reward preferences, basing my research questions on ideas drawn from behavioural economics and economic psychology, in order to obtain a more robust understanding of the relationship between an executive’s pay and their motivation.
Four key points emerged from my research.
Firstly, executives are much more risk-averse than commonly accepted financial theory would suggest, with a majority preferring more certain outcomes over more risky, and potentially more rewarding, options. They also attach a heavy discount to ambiguous and complex incentives.
Secondly, intrinsic motivation is much more important than the prevailing economic wisdom would allow, to such an extreme that many executives would give up nearly 30% of their income to work in more personally satisfying roles.
Thirdly, executives are very high time-discounters. They typically discount the value of complex long-term awards at a rate in excess of 30% per annum, reducing the face value attached to the incentives on offer at the beginning. The longer the executives have to wait, the less valuable the perceived reward at the start.
And finally, fairness matters. Executives are more concerned about their level of reward relative to their peers than in absolute amounts.
The overall conclusion is that the current conventional methods of compensating executives are actually contributing to the rapid inflation of executive pay, as companies are required to provide larger and larger pay-offs to counter the reduced subjective values that executives attach to their offerings.
Having analysed the core issues surrounding the pay-for-performance model of executive remuneration, I’d like to set out six guiding principles for companies:
- Performance-related pay is often expensive and should be used wisely. Performance-related pay is not a universal solution to the pay design question. Executives will expect to be compensated with higher awards because their risk discount factors are up to 50% higher than predicted by financial theory. Firms should think more carefully about how to structure such incentives.
- Short-term incentives are much more efficient than long-term incentives. Deferral comes at a cost, so better to use annual bonuses to signal desired behaviours. Subjective time-value discount factors are much higher than objective financial discount factors.
- Equity plans are inefficient and should be used sparingly. The economic and accounting cost to the company typically exceeds the perceived value such schemes hold for the recipient. Where possible, pay in cash or in other financial instruments whose value is readily appreciated. Executives should be required to invest their own money in buying company shares to align their interests with those of shareholders.
- Complexity destroys value. Executives are not motivated by things they do not understand. Simple but challenging performance metrics are far more effective than complicated packages.
- Fairness matters. Executives assess the value of their incentives and rewards relative to the awards made to their peers. Ensure that pay differentials in the top management team are commensurate with relative contributions and are, therefore, perceived to be equitable.
- Money is not everything. Intrinsic and extrinsic motivation are independent constructs. Extrinsic rewards may crowd out intrinsic motivation. Companies should pay attention to the qualities of the person and to the design of their jobs, not just executive remuneration arrangements.
One way of addressing these issues would be to reward top executives with high salaries and cash bonuses, and to require them to invest a significant portion of their own money in company shares. I am increasingly of the view that long-term incentive plans are best avoided.
Ask the man on the street and he’ll say executive pay needs to be curbed—and I would probably agree. But this is a systemic problem; it would be almost impossible for one company to address the conundrum alone.
Revolutionising executive pay will require change on an institutional scale. Government, regulators and trade associations all have a part to play, and academics must develop new theories of agency and top management motivation to support the development of new top-pay practices.
Alexander (Sandy) Pepper is professor of management practice in the Department of Management at the London School of Economics and Political Science. He is a leading researcher in HR management and labour markets issues, especially the impact of incentives and rewards on the behaviour of senior executives. Before joining LSE, he had a long career at PricewaterhouseCoopers (PwC) where he held various senior management roles, including Global Leader of the HR Service business. Professor Pepper has recently authored The Economic Psychology of Incentives, published by Palgrave Macmillan.